As a follow-up to our posts on the Goosen case regarding sourcing of a golfer’s income from sponsors (seehere), we provide this update on the case involving golfer Sergio Garcia. While they were not technically related cases, the significant overlap in issues and facts—not to mention witness testimony—meant that the outcome in Goosen partially determined the outcome in Garcia.

Both cases involved the character of the golfers’ endorsement income. Coincidentally, the golfers each had an endorsement contract with the same brand—TaylorMade. The golfers both argued that the lion’s share of the endorsement income was royalty income (i.e., paid for the use of the golfer’s name and likeness) and not personal services income (which is typically subject to a higher tax rate than royalties because of tax treaties).

Garcia had sold the rights to his image to a Swiss corporation (of which Garcia owned 99.5%) that in turn assigned the rights to a Delaware LLC (of which Garcia owned 99.8%). Garcia’s amended endorsement agreement assigned 85% of the contract payments to the LLC as payments for the use of his image rights. So Garcia argued that at least 85% of the endorsement payments were royalty income by virtue of the terms of the endorsement agreement. The Service originally argued that none of endorsement payments were royalty income and that all of the payments were for personal services. But the Service later tempered its position and argued that the “vast majority” of payments were for personal services.

Thanks to some testimony by the TaylorMade CEO that undermined the allocation in the agreement, the Tax Court declined to follow the 85/15 allocation in the amended endorsement agreement. But the Tax Court also rejected the Service’s argument that the “vast majority” of payments were for personal services. And the Tax Court determined that a 50/50 split was unwarranted.

In rejecting the 50/50 split, the Court tied the outcome in Garcia directly to the outcome in Goosen. As we wrote before, the Court opted for a 50/50 split between royalties and personal services for Goosen’s endorsement income. But expert testimony in Goosen contrasted Goosen’s endorsement income with Garcia’s. The expert in Goosen (Jim Baugh, formerly of Wilson Sporting Goods) had testified that, while Goosen had better on-course results than Garcia, Garcia had a bigger endorsement deal because of Garcia’s “flash, looks and maverick personality.” Consequently, the Court found that Garcia’s endorsement agreement “was more heavily weighted toward image rights than Mr. Goosen’s” and decided on a royalty/personal services split of 65/35.

The Tax Court also rejected the Service’s argument that Garcia’s royalty income was taxable in the U.S. under the U.S.-Swiss treaty. Perhaps the IRS will appeal that legal issue. Will Garcia appeal? The Tax Court’s decision is a victory for Garcia relative to the outcome in Goosen. On the other hand, if Garcia’s brand hinges on his “maverick personality,” then perhaps the “maverick” thing to do is to roll the dice with an appeal. Decision has not yet been entered under Rule 155, so we will wait to see whether there is an appeal.

While this post is significantly belated, it’s still worth noting that the IRS (the original appellant) and Goosen (who had cross appealed) stipulated to dismiss the appeal to the D.C. Circuit back in February.

This doesn’t mark the end of the IRS’s fight with pro golfers over the character and source of income (especially royalty income). Sergio Garcia disputed deficiencies on similar issues; his case was tried in the Tax Court back in March. (Case No. 013649-10). We’ll update you when the decision is issued in that case.

We posted in November 2011 about the Tax Court’s decision on the character and source of golfer Retief Goosen’s endorsement income. The Service appealed that decision to the D.C. Circuit in December. The D.C. Circuit case number is 11-1478. We’ll post updates as the appeal progresses.

In what appears may be the first in a series of cases on the endorsement income of non-resident aliens, the Tax Court was tasked with characterizing and sourcing the endorsement income for golfer Retief Goosen. The court’s decision may impact how other athletes and entertainers structure their endorsement deals and indicates how taxpayers should expect the IRS to source royalty income in similar cases.

Goosen, a native South African who is a U.K. resident, is subject to U.S. tax because playing professional golf in the U.S. amounts to engaging in a U.S. trade or business. He had endorsement agreements with Acushnet (which makes Titleist golf balls), TaylorMade, and Izod to use or wear their products while playing golf (these are the “on-course” endorsements). He also had endorsement agreements with Rolex, Upper Deck, and Electronic Arts (the “off-course” endorsements).

There were three main issues before the Tax Court:

(1) Was Goosen’s on-course endorsement income personal services income or royalty income or some combination of the two? (The parties agreed that all of the off-course endorsement income was royalty income.) The personal services income of nonresident aliens is subject to regular U.S. tax rates; they typically owe less U.S. tax on royalty income under tax treaties.

(2) What portion of Goosen’s royalty income was U.S.-source income? Under section 872, the gross income of nonresidents includes U.S.-source income.

(3) What portion, if any, of that U.S.-source royalty income was effectively connected to a U.S. trade or business? While U.S.-source royalties are generally subject to a flat 30% withholding tax, if royalties are effectively connected to a U.S. trade or business, they are subject to the graduated rates that apply to U.S. residents.

On the first issue, Goosen argued that the on-course endorsements were paid for the use of his name and likeness, which is classic royalty income. The IRS argued that because the on-course endorsement agreements required Goosen to make personal appearances and to play in a minimum number of golf tournaments (all while using Titleist balls and TaylorMade clubs and wearing Izod), the on-course endorsements were paid for personal services. The court split the difference, deciding that the sponsors paid for both the use of Goosen’s image and likeness and for personal services.

On the one hand, the court found that the sponsors were paying for more than just Goosen’s golfing—that the sponsors wanted to be associated with Goosen’s image. The court cited the morals clause in a couple of Goosen’s endorsement agreements as evidence that the sponsorship was about more than just golfing. (This morals-clause discussion enabled the court—and, conveniently, this blog entry—to meet the requirement that anything written about golf must mention Tiger Woods.)

The court also cited expert testimony from Jim Baugh (formerly of Wilson Sporting Goods) for the proposition that image is sometimes more important than performance. Baugh testified that while Goosen has won more and consistently been ranked higher than golfer Sergio Garcia, the two have effectively identical endorsement agreements with TaylorMade. Baugh attributed this to Garcia’s “flash, looks and maverick personality.” This is notable testimony because Garcia has his own Tax Court case pending, which is set for trial in Miami in March 2012. By detailing this testimony, the court gifts Garcia with a tailor-made argument that, relative to Goosen, a greater portion of Garcia’s TaylorMade endorsement income is royalty income.

On the other hand, the court held that the endorsement income could not be solely attributable to Goosen’s image. After all, the on-course endorsements required Goosen to make personal appearances and to play in a specified number of tournaments, all while wearing or using the sponsors’ products. Acknowledging that precision in allocating between royalty and personal service income was unattainable, the court settled on a straightforward 50-50 split.

As for the second issue, the court was left to decide what portion of Goosen’s royalty income was U.S.-source income. Generally, the source of royalty income from an intangible is where the property (in this case, Goosen’s image) is used. With respect to the Upper Deck and EA endorsements, the court looked to the relative U.S.-to-worldwide sales percentages of Upper Deck’s golf cards (92% in the U.S.) and EA’s video games (70% in the U.S.) and then sourced Goosen’s royalty income accordingly. For the three on-course endorsements and the Rolex endorsement, the court determined that while Goosen was marketed worldwide, the U.S. constitutes about half of that worldwide golf market. The court therefore treated half of the income from those four endorsements as U.S.-source income.

Finally, the court had to decide whether any of that U.S.-source income was effectively connected to a U.S. trade or business. The court held that only the on-course endorsement royalty income was effectively connected to a U.S. trade or business. The court found that since the off-course endorsements didn’t require Goosen to play golf tournaments or to be physically present in the U.S., that royalty income was not effectively connected to the U.S.

The aspect of the decision that seems to have scared some practitioners (other than the existence of a worldwide market for collectible golf cards, which maybe scares only this practitioner) was how the court sourced royalty income according to the U.S.-to-worldwide sales percentages. The fear is that the IRS will simply apply those percentages in every case, and taxpayers will have no room to negotiate a more favorable allocation.

We’ll keep an eye on where this case heads and will post updates on the Sergio Garcia case.

About Miller & Chevalier’s Tax Appellate Blog

Miller & Chevalier was founded in 1920 as the first federal tax practice in the United States. For nearly 95 years, the firm has successfully represented the most sophisticated corporate clients in all facets of federal income taxation. Miller & Chevalier’s Tax department serves clients headquartered throughout the U.S. and around the world and, over the past several years, has represented approximately 30 percent of the Fortune 100 and more than 20 percent of the Global 100. Our clients come to us to solve the thorniest of tax issues, and we have litigated many of the most significant tax cases on record.

The Tax Appellate Blog is intended to be a resource for information on important tax cases under consideration in the appellate courts. It will feature insightful commentary on the issues and provide a dedicated site for following the progress of these cases.

Authors

Steve Dixon is a Member in the Tax Department at Miller & Chevalier. He specializes in controversy and litigation, representing taxpayers in the Tax Court and Federal courts.

Laura Ferguson is a Member of the Supreme Court and Appellate Litigation Group at Miller & Chevalier and has successfully briefed and argued six cases at the U.S. Courts of Appeals in the past two years. Ms. Ferguson also has extensive experience litigating complex, high-stakes tax cases at the Tax Court and federal district courts.

Alan Horowitz is the former Tax Assistant to the Solicitor General at the Department of Justice, where he briefed and argued numerous tax cases in the Supreme Court. He is currently the head of the Supreme Court and Appellate Litigation Group at Miller & Chevalier.